Since December 31, the Corona, CA-based generic drug maker's stock had nearly doubled, hitting an all-time high of $71.50 earlier this month.

But on September 12, the company, which has a market capitalization of $5.4 billion, announced it would miss analysts' earnings expectations by a lot. The stock plummeted by 26% in just two days.

Watson said it expects to report third-quarter earnings of three to five cents a share, far below First Call's recent consensus estimate of 48 cents. Plus, it guided analysts' earnings estimates downward for this year and next.

The problem? The company must cut sales to correct an inventory backlog at newly acquired Schein Pharmaceutical.

Wall Street quickly leaped to Watson's defense. The pros argue that the earnings shortfall will be temporary and that the company should still benefit from a robust environment for generic drug makers.

Watson has developed a broad pipeline of products, many of which are awaiting approval by the Food and Drug Administration. The company has a fast-growing brand-name pharmaceutical business, too. And the shares are a lot cheaper than they were before.

"While the earnings announcement was clearly disappointing, it didn't change the long-term outlook," says Angela Larson, an analyst at Salomon Smith Barney. "Watson, I believe, is very well positioned for the near-term patent-expiration cycle."

The company said pricing competition for its acne medicine, Monodox, hurt a bit. And it noted that goodwill amortization related to its acquisition of Schein would be greater than expected, because Watson's share price had risen so much before the deal closed.

But the primary reason for the shortfall was that Schein had allowed its customers to amass a backlog of four to six months' worth of inventory -- in other words, "stuffing the channel."

"Schein has done very, very aggressive forward selling for a long time," explained Watson CEO Allen Chao during a conference call last week. "Obviously, that's a major problem."

Most generic drug makers sell products in advance because customers like to buy in bulk at lower prices. But Watson maintains only a 1 1/2- to 2 1/2-month inventory buildup.

Watson opted to bleed down Schein's inventory to bring the two companies' practices in line. Chao said it was "a tough decision," but necessary so customers would view the combined entity as a single, broad-based business.

So, Watson is reducing sales to give customers a chance to trim their inventories. Schein's extra four months' worth of inventory should be gone by the end of the year, and Watson said sales should return to normal by the first quarter of 2001.

"We see that as a temporary problem," observes Nick Azari, manager of the Icon Health Care Fund, which owns about 60,000 Watson shares.

He and other bulls are focused instead on what Richard Silver, an analyst at Lehman Brothers, calls an "unprecedented" opportunity for the generic industry in the next few years.

By 2005, patents should expire on brand-name drugs accounting for some $30 billion in annual sales, opening the door for generic competition (see Weekday Trader, "Political Winds Could Blow Generics' Way in 2000 ," January 27). In addition, as politicians harp on drug prices, legislation is likely to favor the low-cost knockoffs.

Watson, which posted 1999 revenue of about $690 million, is among the top three generic drug makers, with some 150 drugs on the market.

The company also has 24 more generic drugs pending before the Food and Drug Administration and five that have tentatively been approved. It expects to launch several drugs by the end of 2001, generating an incremental $130 million in revenue, Chao said.

Among those, the anti-anxiety drug busparone may be the most promising. Marc Goodman, an analyst at Morgan Stanley Dean Witter, believes the product will reap about $20 million in revenue next year because Watson will probably win six months of marketing exclusivity for certain dosages.

Meanwhile, Watson should continue to see steady growth in its brand-name drug business, which the company expects to produce about half its sales next year.

The branded dermatology line took a hit when, ironically, a competitor launched a cheap generic alternative to its proprietary Monodox. But Watson's women's health division, which is growing by about 30% annually, should make up for the shortfall, Larson believes.

And the Schein acquisition should begin to pay off, too. Watson expects to squeeze about $50 million in cost savings out of the merger next year.

Already, the stock has rebounded about 10% from its September 13th close. At $56 late Monday afternoon, it changed hands at around 23.5 times First Call's revised consensus 2001 earnings per share estimate of $2.38.

That's 1.12x the company's projected long-term growth rate of 21%--down from 1.38x earlier this month. Meanwhile, Watson's peer group has an average price/earnings-to-growth (PEG) ratio of 1.32x, based on 2001 earnings. And Watson remains 22% off its high.

"It still is a good value," asserts Azari.

Of course, some investors believe Watson should have uncovered the problems at Schein earlier. They would, no doubt, be less forgiving if Watson stumbles again in its integration of Schein.

But John Schaetzl, an analyst at GE Asset Management, thinks the slipup was uncharacteristic of Watson's strong management. "One mistake shouldn't cause you to throw the baby out with the bath water," says Schaetzl, whose company owns about 59 million Watson shares.

He's giving Watson a second chance. And, if the bulls are right about Watson's good market position, pipeline and branded business, he'll be glad he did.

Bulls Say It's Elementary -- Buy Watson

T he New Millennium had been downright amazing for Watson Pharmaceuticals -- until last week, that is.

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